by Asli Demirguc-Kunt and Ross Levine

Concentration in the banking industry may have far-ranging and long-lasting implications for financial sector efficiency, bank stability, industrial competitiveness, and the policies, regulations, and institutions essential for long-run economic growth.1 Some argue that concentration will intensify market power and thereby stymie competition and efficiency. Others argue that economies of scale drive bank mergers and acquisitions, so that increased concentration goes hand-in-hand with efficiency improvements. In terms of stability, greater concentration may augment the size, market power, and profits of banks, and thereby enhance diversification and create greater incentives for secure banks to avoid imprudent risk-taking. On the other hand, bigger, politically connected banks may become more leveraged and take on greater risk since they can rely on policymakers to help when adverse shocks hurt their solvency or profitability. Similarly, large, politically influential banks may shape the policies and regulations influencing bank activities. Moreover, powerful banks may influence tax systems, anti-trust legislation, the degree of corruption, and a broad set of institutions governing economic interactions in ways that help banks, but not necessarily in ways that help the overall economy. Finally, policymakers frequently use concentration as a proxy for competition. While excessive competition may create an unstable banking environment, insufficient competition – and contestability – in the banking sector may breed inefficiencies. For these reasons, policymakers are concerned about commercial bank concentration.

Not only is commercial bank concentration an important public policy issue, the degree of concentration is quite different across countries and is changing rapidly in some nations. Over the period 1990-7, the average level of bank concentration – measured by the fraction of commercial bank loans controlled by the three largest banks – across 99 countries was 0.72, but ranged from 1.0 to 0.2, with a standard deviation of 0.2. Over this period, the level of concentration in India rose from 0.44 to 0.88 and France's bank concentration ratio jumped from 0.27 to 0.46. The United States also experienced numerous "supermegamergers" involving over $100 billion each (e.g., Citicorp-Travelers, BankAmerica-NationsBank, Banc One-First Chicago, etc.). Moreover, in many countries, the merger of two foreign banks may importantly influence domestic bank concentration if those foreign banks had a substantial share of the domestic market. For instance, the purchase of Banco Santiago by Banco Santander -- two Spanish banks -- induced intense concern in Chile because of its impact on the Chilean banking sector. Since mergers are expected to intensify in the next decade, bank concentration is likely to receive even more attention from policymakers in coming years.

Though a central policy issue around the world, existing empirical work on bank concentration has two notable weaknesses: (1) research overwhelmingly focuses on the United States banking industry and (2) there is an absence of econometric evidence on the political economy aspects of bank concentration. Microeconomic studies of the banking industry of the United States have produced convincingly ambiguous evidence: it is difficult to argue that greater bank concentration is strongly linked – positively or negatively – with changes in financial sector efficiency or bank stability. While rigorous and useful, studies of the U.S. may not be directly applicable to developing countries. For instance, the United States has over 23,000 banking institutions, which is large even compared to Japan (4,635), Germany (3,509), and France (547).2 The United States has very well developed nonbank financial markets and institutions, while developing economies frequently do not. The United States has legal, regulatory, and political institutions that are very different from many developing country systems. In terms of the political economy aspects of bank concentration, existing research on commercial bank concentration has yet to shed much direct evidence on the relationship between bank concentration and the enactment of financial sector policies, bank regulations, corruption, and other institutions. Thus, important work remains.

This paper contributes to the literature both by extending the analysis of bank concentration to a broad cross-section of countries, including developing countries, and by directly examining the political economy aspects of bank concentration. Regarding the first contribution, we study the relationship between bank concentration and measures of financial sector efficiency, bank stability, industrial competitiveness, and a wide range of policies, regulations, and institutions essential for economic interactions in a cross-section of up to 94 countries. The strength of our research is to extend the literature beyond the United States (and a few other country studies) to a wide-array of countries. The weakness of our work is that we use broad cross-country comparisons instead of detailed, microeconomic studies of individual banking sectors. Future research involving microeconomic studies of the determinants and implications of bank concentration in developing countries would materially improve our understanding of bank concentration.

This paper's second contribution is that it studies the relationship between bank concentration and the structure of the tax system, tax compliance, policies toward industrial competition, political corruption, and the efficiency of legal and accounting systems. While policymakers are concerned about banking sector efficiency and stability, it is critical to assess the impact of concentration on the political economy of a nation because this will shape a broad array of policies, regulations, and institutions. For instance, concentrated, powerful banks may argue against granting generous deposit insurance since that levels the playing field for smaller banks that do not enjoy the too-big-to-fail policy of most governments. Similarly, big banks may argue successfully against regulations restricting their ability to expand into securities, insurance, real estate, and other businesses. Concentrated banks may seek to stymie stock market development by pushing for higher taxes on capital gains and by discouraging regulations that (1) protect the rights of small investors and (2) promote accounting transparency. To boost the profitability of large clients, powerful banks may also seek to control "unruly" markets by weakening anti-trust laws and other policies designed to promote competition. Finally, if concentrated powerful banks unduly influence the formation of policies and regulations, this may hinder political integrity and reduce tax compliance. While this is speculative, these linkages are not implausible, have extensive implications, and are uninvestigated. This is the first paper that systematically assesses the links between bank concentration and a wide assortment of policy, regulatory, and institutional factors that influence economic development.

Specifically, we assess whether banking system concentration (as measured by the share of the loan market controlled by the three largest banks) is strongly linked with:

Protection of outside investors (minority shareholders and creditors) in firms,

Transparency and accuracy of the corporate financial statements.

This paper's results address each of these considerations. Bank concentration is not strongly linked with measures of financial sector development and efficiency. While there is frequently a negative relationship between bank concentration and stock market liquidity, this relationship is not robust to changes in the condition information set or different indicators of liquidity. These results hold after controlling for other features of the banking and economic environment, such as public bank ownership, the role of foreign banks in the economy, openness to international trade, and the level of economic development.

Bank concentration is negatively associated with restrictions on bank activities, but the relationship between bank concentration and other financial sector policy indicators is weak – albeit frequently of the anticipated sign. Specifically, bank concentration is not statistically significantly associated with the generosity of the deposit insurance regime, the personal income tax rate, or the tax rates on interest, dividend income or capital gains. We do, however, find that countries that permit their banks to engage in a wide range of financial activities also tend to have relatively high levels of bank concentration. These results hold after controlling for the overall level of economic development, the role of foreign banks in the economy, the degree to which state-owned banks dominate the banking landscape, and openness to international trade. Causality is difficult to untangle, however. It is unclear from our analyses whether the lack of restrictions leads to a concentrated banking system, or whether concentrated, powerful banks lobby to prevent restrictions on their activities.

Bank concentration is strongly linked with the integrity of (lack of corruption in) the political system, but it is not robustly linked with measures of industrial competition of institutional development. Specifically, countries with higher levels of bank concentration tend to have higher levels of political integrity, i.e., lower levels of corruption. It may be the case that countries with high levels of political integrity do not fear the corrupting influences of bank concentration and therefore permit greater bank concentration. To assess whether bank concentration has a strong independent relationship with financial development, bank efficiency, bank policies and regulations, industrial competition, and institutional development after controlling for political integrity, we re-ran all of the regression in this paper while controlling for political integrity. This does not alter the paper's conclusions.

Finally, we examine the relationship between bank concentration and the fragility of the banking system. Specifically, we run logit regressions to assess the association between bank concentration and the probability that a country suffers a major banking crisis. While there is generally a negative relationship between concentration and the probability of a crisis, this relationship is not robust: there is not a robust link between bank concentration and banking sector fragility.

It is important to qualify and clarify this paper's conclusions. Policies, laws, and regulations concerning commercial bank competition are likely to remain important public policy issues. This paper's international comparisons simply suggest that greater concentration per se is not closely associated with banking sector efficiency, bank fragility, financial
development, industrial competition, or a broad range of institutional indicators. While one may
question the accuracy of individual data series, the consistency across a wide array of variables
strengthens the conclusions. These results may be interpreted as casting doubt on the usefulness
of concentration as an accurate proxy for competition and contestability. Thus, future research
that focuses more precisely on regulations, laws, and policies that directly restrict competition
and contestability in the banking system may provide more informative results. Also, we
conduct broad, cross-country comparisons. These results do not imply that concentration is
unimportant for any particular country. Country-specific factors are certainly critical. The
analyses do suggest, however, that it would be difficult to argue for or against bank
concentration based on broad international comparisons.

The remainder of the paper is organized as follows. Section II reviews theoretical and
empirical research on bank concentration. Section III defines the data, motivates the
conditioning information set, and describes the econometric methodology. Section IV presents
the results and Section V concludes. Read the entire document here.

Demirguc-Kunt is lead economist with the World Bank. Levine is a professor at the University of Minnesota. Pam Gill provided
extraordinary research assistance for this paper.

1 We cite specific authors in section II when we review theoretical and empirical research on the determinants and
effects of bank concentration. Here, we simply state some of the broad issues surrounding bank concentration.

2 These statistics are for 1996 and are taken from Berger, Demsetz, and Strahan (1999, Table 5), where the primary
data source is the Bank of International Settlements.

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FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.